Larry Swedroe on Passive Investing and Skill

Swedroe, an avowed proponent of passive investing, wanted to clarify his position. It’s not that investing skill can’t exist, he argued, it’s that if it does, the markets will, over time, erase that advantage. And, just as importantly, that it’s impossible to predict where that skill will show itself. We’re betting against the odds if we try to pick the winning investors (or fund managers).

The nature of the game is not like baseball, tennis, chess, etc. where skill persists–because those are one-on-one games, where small advantages matter a lot. But investing is the competition of the entire market against each person, and the evidence suggests overwhelmingly that the wisdom of the crowd is a very tough competitor indeed and success sows the seeds of its own destruction.

The passionate responses that followed lead me to contact Mr. Swedroe to see if I could ask him a few follow up questions myself.

In the course of our conversation, he told me why he spends part of his Sundays — and many other days of the week — on investing chat boards and answering investor emails. Swedroe comes from modest beginnings. When he was young he slept in the kitchen of his family’s apartment in the Bronx, before eventually moving up to sharing a bedroom with his brother and sister. He had a successful finance career, though, running major business lines for Citicorp, and making enough to retire well when Prudential Home Mortgage, where he was then vice chairman, was sold in the mid 1990s. He thought about teaching, but decided instead on writing as a way to educate. Today he writes a regular blog for CBS Marketwatch and has written nine books. “This is my passion, my way of paying it forward,” he says. “I’m trying to prevent the wolves of Wall Street from sheering the sheep and they keep lining up to be sheered.”

Here is an edited transcript of a bit of what we talked about:

Portfolioist: You quote loads of research that supports your position that investors lose out when betting on actively-managed mutual funds. And the Bogleheads is a discussion forum with a strong bias toward Vanguard-style, low-cost, index investing. So why do you think, even there, readers argue this point?

Swedroe: People want to believe there’s somebody who can predict where things are going. Despite all the evidence that there are no seers, people will still pay a lot of money to believe there are seers…Philip Tetlock is an expert in political judgment, where it’s much more important to get the forecast right. Does Saddam Hussein have weapons of mass destruction, for example. In his book Expert Political Judgment: How Good Is It? How Can We know? he writes about the people who advise the CIA, etc., and their forecasts are lousy. There are no good forecasters.

Tetlock describes the hedge hogs and the foxes. Hedge hogs look through a prism. You can tell them something is black and they’d say it’s white. You can’t convince them. Hedge hogs know a lot about a little. Foxes know a little about a lot. If you’re a fox and I try to convince you your position is wrong, I might get you pulled into the middle. It’s the hedge hogs who are more sure they’re right. Neither are good predictors, but hedge hogs are worse. They’re like Nouriel Roubini [who’s negative predictions have made him famous in the last few years]. On occasion they’ll be right, like a broken clock is right twice a day. The foxes pick moderate outcomes, they get it more right, but the hedge hogs get more famous. They’re on CNBC for the next few months.

There’s an old saying about forecasters, from John Kenneth Galbraith, “There are two classes of forecasters: Those who don’t know and those who don’t know they don’t know.” I say there’s a third type: Those who know they don’t know, but get paid a lot of money to pretend they do.

Portfolioist: Your argument isn’t that there’s no chance an investor can be skilled.

Swedroe: [Academics Kenneth R.] French and [Eugene F.] Fama wrote the paper on skill versus luck. They say what we do know is there are so few funds that outperform, we can’t differentiate skill from luck. An investor might [pick the] right [fund], but the odds are so low that they’re right, it’s not prudent to take that risk.

You only hear about (Yale Endowment’s chief) David Swensen, but how many others failed trying to do exactly the same thing? I’m not saying Swensen doesn’t have skill and Warren Buffett doesn’t have skill. I’m saying I can’t find the future Buffett today. The very few who outperform, especially in taxable accounts, outperform by very little on average.

Portfolioist: So just buy the market and go away?

Swedroe: Don’t confuse index investing with just buying an S&P 500 fund. In The Only Guide You’ll Ever Need for the Right Financial Plan, I describe how much small company stock, emerging markets, real estate you want to have, and having the right amount of high quality fixed income. You need to decide on a geographic division too. I tell people 50% international, 50% US is logical, but 30% international is better than 0 and it’s better than 10% which is what the average investor has.

Portfolioist: You advocate investors focus on what they can control: costs, diversifying their investments to reduce risk, rebalancing to maintain that asset allocation, being smart about your taxes. Presume somebody has done all that right, then do they have to worry about valuation?

Swedroe: Yes and no. There is no way to know what the right price for stocks is. Say the average price to earnings ratio is 15. 10 could be right. 20 could be right. Now 40 can’t be right – I’m not saying bubbles don’t happen but they are easy to spot.

Say you think stocks will return 10% and bonds 4%. For a 50/50 split, you’ll get 7%. But if stock prices go much higher, like they did in 1999, maybe you’d get 5%. [Because they’re already expensive they’re less likely to rise, so your projected return from equities will have to drop sharply.] You have to change your goals. So you have to know how projecting future returns is (affected by valuation.)

Let’s say stocks have a dividend yield of 2.5%, inflation is 2%, and you expect additional long term growth in earnings of 2.5%. [Add those together,] you’re at 7%. If bond yields are at 3%, a 50/50 split gets you to 5% yield on your investments. If you need more, you need to own more equities. You need to be able to project and understand that. Stocks always should have a risk premium, sometimes it’s bigger than others.

Portfolioist: Just because we predict 7% doesn’t mean we’ll get it.

Swedroe: Get a piece of paper. [Swedroe has me draw a bell curve, with a line down the middle marked 7%.] 7% is your expected return going forward. Is that a guarantee? No. That’s the wrong way to think about it. The thing to think about here is the potential dispersion of returns. You should also consider that there might be a 10% chance you’ll get more than 9%. 5% you’ll get more than 10%. But over on the left side, there’s a 2% chance we’ll end up like Japan [with no stock appreciation for a long time.]

People think of stocks as risky investments. That’s wrong. There’s a difference between risk and uncertainty. If you go to the craps table you can calculate whatever the odds are of a certain roll of the dice. That’s risk. Insurance companies have huge databases that help them get a good estimate that I’ll live to 80. They can’t be sure, there’s some uncertainty, but that’s close to risk.

But in the world of investments can you tell me what the odds are? No. That’s uncertainty. That’s why stocks have such a big premium. Because people don’t want to make bets that have uncertainty.

Portfolioist: So then we should be avoiding those seers as you call them, not searching for them.

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8 thoughts on “Larry Swedroe on Passive Investing and Skill”

A discussion has sprung up on the Boglehead’s board regarding Swedrow’s discussion of risk in this interview, and pondering what is the right definition of risk. Link: http://www.bogleheads.org/forum/viewtopic.php?t=61276&mrr=1286691972
One person argues that risk is something that will become divided into many sub-categories as we grow to better understand it over time — so that there will no longer be term with one definition.
Is risk volatility? Is it the “possibility of an unhappy outcome” as one Boglehead writes? Or is it another readers’ suggestion: “Risk = Probability * consequence”?
Or something else?

Thank you for this interview – I find it fascinating, especially your discussion about valuations.

When the P/E ratio rises the expected return from equities drops, then to achieve the same fixed number for an investment portfolio’s expected return one would need to hold a higher percentage of equities. This makes sense to me. However after P/E ratios have risen significantly, presumably many investors have a reduced need to achieve the same fixed return going forward – because its likely they’ve recently had very favorable returns and can thus take some risk “off the table”. If recent equity returns have been generous, it is likely that investors can reduce their required future return to achieve their goals, and correspondingly may be able to reduce their equity percentages. Do you concur?

This is a straightforward concept yet it seems human emotions sometimes can make it difficult to act upon.

Steve
Answer depends. If you are close to your goal then absolutely yes, the need to take risk has been reduced and you should lower your allocation to stocks. But if you are young and early in accumulation phase then the reverse is true, unfortunately. The reason is that stocks now have lower expected returns and thus to achieve your goals you need to take more risk (not saying you should, but simply stating a fact). While you would have benefited from the bull market, your gains are on relatively smaller amounts and now the future returns will be expected to be lower.
The best thing for older investors was the bull market of the 90s but it was the worst thing for younger investors.

I hope that is helpful

Here is something that should also be of help. Higher than historic returns means that long term returns are now higher and the mistake investors make is to then extrapolate the higher long term returns into the future, which of course makes no sense. Future returns will be expected to be lower due to higher valuations, and your plan should take that into account.

Steve
Glad to be of help.
If you like to read about the “science” of investing I am sure you will enjoy my blog at http://moneywatch.bnet.com/investing/blog/wise-investing/?tag=col2;blogroll
And if have not discovered my books, you can check them out at Amazon.com, especially the four Only Guides and the 2 Wise Investing books. And one of the benefits is that I am always happy to answer questions from readers.

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